The Index Fund Problem

"If everyone is thinking alike, someone isn't thinking."  General George S. Patton

For believers in Efficient Market Theory (EMH), the choice is clear:  you can't beat the market, so you might as well invest in it via index funds.  The logic here is that by doing so, you can nearly match the market's performance.  It certainly sounds good:  the fees are low, and many of these funds match the market quite well, considering all the apparent evidence that most of the other types of mutual funds tend to underperform.

Burton Malkiel is credited as one of the first popularizers of the index fund idea, and index funds to this day are often recommended to investors by some of the biggest names in the industry.  But then Rob Arnott caused a stir in 2004 by finding that "market" index funds are intrinsically inefficient, and that they could be beaten.  Other studies detected herding behavior in index fund investors (PDF).  In other words, by doing exactly what they were supposed to in an efficient market, they were exposing themselves to exploitable inefficiencies (stay tuned for the next post where this idea is explored in more detail).  This is quite a paradox, and probably somewhere therein lies a proof of why markets can never be fully efficient.

The irony is that the solutions forwarded to solve these problems begin to erode the various forms of the EMH.  Fama and French have their three-factor model, which takes into account such things as book value and Jeremy Siegel touts fundamental index funds which do fundamental analysis.  In other words, buy index funds that assume the market isn't as efficient as the EMHers believed it was.

My conclusion is that in the markets, it's good to realize the implications of Patton's reformulated advice:  If everyone is investing alike, someone isn't thinking.

This is not to say index fund investing is bad.  The nature of an economy is that we all get paid to "think" about different things.  Under the Adaptive Market Hypothesis (AMH), some will get paid to think about and arbitrage the markets, primarily by those who don't - it's simply a fee that in a competitive market will be as low as possible.  So index fund investing is good for people who don't want to spend time thinking about the markets.  The point is there is a fundamental problem (tragedy of the commons) when everyone tries to get in the same lifeboat of the Titanic market - there's only room for so many to efficiently board. 

Update: Siegel vs. Bogle on Index Funds; more here

Battle over best indexing strategy rages

The poor standard of Standard and Poors

Beating the Index Bogey

Comments

[Jim Winkelmann]

I really like your blog. Our Blue Ocean Portfolios combines indexing with a "version" of Claude Shannons rebalancing theories. Our rebalancing is based on deviation triggers not calenders. Becuase we use 11 diffent indexes and US Bonds (no cash) we rebalance when the various parts of the markets randomly move against each other. I think Shannon had it right but we take it another step further becuase we can pick additional returns in the other asset classes. Fortunes Formula has us contemplating a more active rebalancing scheme.

Thanks

Jim Winkelmann

[Alan J]

Jim,

Thank you. It sounds as if you have a different version of indexing going, with a broader approach. I am certainly a fan of the Shannon approach, as well as Kelly. It seems to me rebalancing and index funds go well together on many levels. Good luck in your endeavors.